I usually don’t simply refer readers to someone else’s work, but I thought this FT story is particularly intriguing.
haves and have-mores
The consulting firm McKinsey and Company published a study on the digital economy last month, titled “Digital America: A tale of the haves and the have-mores.”
It makes two main points:
–the price of information and communication technology goods and services has dropped by about 2/3 over the past two decades. So conventional measures of GDP are probably underestimating the positive impact of ICT on overall economic growth in the US.
More important for us as investors,
–the pace of digitization varies very widely by company and by industry. The leaders have increased their digital capabilities over fourfold over the past 15 years. The rest have 14% of the leaders’ digital presence. That’s up from 8% in the late 1990s. But the great mass of firms have barely closed any of the gap.
Laggards have only a fifth of the digital assets of the leaders and have only 7% as many workers performing digital tasks.
Interestingly, McKinsey lists as the most digitized sectors:
Finance and insurance (insurance?).
I guess I have to remember it’s a relative list.
The least digitized are:
Agriculture and hunting.
McKinsey also points out that the most digitized–think Google, Facebook, Amazon, Netflix–have an immense competitive advantage over their rivals. That expresses itself in increased market share and higher profit growth–although personally I think we have to take the second on faith with firms like AMZN, which are plowing their cash flow back into expanding their reach.
In a year that will probably be flattish–even though the first couple of trading days make one think of flattish as an aspirational goal–looking to firms who are establishing digital leadership is a reasonable investment strategy. Growth investors will likely try to find fast-growing leaders, both large and small. Value investors will probably try to find laggards who now understand their potential predicament and are acting aggressively to remedy their shortcomings.
All we have to do is find names.
Yesterday I outlined the McKinsey argument that a substantial “equity gap” will emerge in developing economies between the demand for stock financing for capital expansion and the money that investors are willing to make available to the firms that need it.
I believe the qualitative story
To recap: The qualitative argument the consultant makes starts with the idea (which I think is correct) that stock markets in almost all emerging nations are hazardous to investors’ wealth. The companies listed may be the politically connected dregs of the local economy, not the stars. Financial statements may not be reliable. Corporate management may not have shareholder welfare as a primary goal. The regulatory playing field is probably heavily tilted toward insiders. It’s ugly out there.
Firms may not find it easy to raise money under these conditions. Foreigners are unlikely to help, either, since in the developed world an aging investor base isn’t likely to have risk assets to spare.
Therefore, emerging economies will only fill the potential we all believe they have if their governments make substantial changes in their stock markets. Otherwise, companies in these countries will come up $12.3 trillion short of their equity funding needs by 2020.
This is a problem, not only for these countries but also for any investors who have bought emerging markets index funds or ETFs banking on emerging economies to flower fully.
It’s the quantitative stuff that I have problems with. Specifically,
1. starting with a quibble…
McKinsey projects that global financial assets will be worth $371 trillion in 2020. It’s not $370 trillion. It isn’t $372 trillion, either. The precision of the figures implies that McKinsey can forecast the state of financial markets almost a decade ahead with an accuracy of +/- .25%. All the empirical evidence is that no one can forecast with this degree of accuracy even one year ahead. Stock market participants know the limitations of forecasts, because the real world beats them over the head with their misses every day. Why isn’t McKinsey aware?
…or maybe not
The “equity gap” McKinsey forecasts amounts to $12.3 trillion (not $12.2 trillion…). That’s 3.3% of projected financial assets in 2020. How much of the “gap” would remain if McKinsey didn’t stick with overly precise point forecasts?
2. using local GDP to forecast corporate profits
McKinsey assumes that the profits of publicly listed companies in a given country will rise in line with nominal GDP. Three reasons why I think this is a mistake:
–many parts of the local economy may not be represented in the stock market. On Wall Street, for example, autos, housing and real estate–all pretty sick sectors at the moment–have virtually no stock market representation
–in the US and UK, at least, publicly listed firms tend to represent the best and the brightest of the local economy. Private equity and trade acquisitions winnow the elderly and the infirm from the herd.
–in the developed world, foreign sales and profits make up a considerable portion of the stock market’s total. In the UK, for instance, maybe 75% of the earnings of the FTSE 100 come from outside that country–explaining its dominant stock market size in the EU, despite not being the largest economy. In the US, the best guess of S&P is that foreign earnings make up about half the total. The figure is rising.
My conclusion(s): the method McKinsey uses will understate corporate profits, and thereby the size of future equity market. This is not new news. Wall Street has been actively discussing the increasingly non-US nature of S&P profits for the past two decades. In other markets, it’s been a key subject for much longer.
3. we live in a post-internet world
It isn’t just the internet, either. Other key factors as well have conspired over the past couple of decades to substantially decrease the capital intensity of business.
–development of sophisticated supply chain control software, combined with internet communication and the rise of specialized logistics/transport firms, means everyone holds smaller inventories
—for many industries, today’s capital spending = servers and software, not machine tools and buildings. The rise of technology rental, software-as-a-service, for example, means decreasing capital intensity
—e-commerce has vastly decreased the requirement for repeated expensive advertising campaigns and ownership of physical retail outlets as tools to make potential customers aware of a product or service.
—the separation of design and manufacture that the internet allows means that companies use less capital intensive processes to make products in low labor-cost countries
in developing economies, too
There’s no doubt that emerging nations will still need a lot of development in capital intensive areas, like power generation, chemicals, water, roads, ports and related infrastructure. But there’s no reason to believe that these economies won’t also avail themselves of the same capital-saving devices in other areas that developed nations now do. For instance, eastern China is already outsourcing some manufacturing operations to lower labor-cost countries.
My point: in projecting the future capital needs of publicly trade firms the McKinsey assumption that companies will be as capital intensive as they have been in the past is the simplest one. I don’t think it’s right, though. In fact, the more I think about it, the odder it sounds.
A final thought on this subject: as prices change, behavior adjusts. If the cost of equity capital were to begin to rise, companies will rethink their spending plans and economize/substitute.
the McKinsey financial markets report
The McKinsey Global Institute just published a research paper titled: “The emerging equity gap: Growth and stability in the new investor landscape.”
The paper is the product of research by McKinsey consultants, in conjunction with “distinguished experts” from the academic world, government and private financial companies. No actual bond or equity market investors appear to have been asked to help with the work, with the possible exception of the head of index products for a UK insurer.
The study’s conclusion: by the end of this decade there could be a shortfall of $12.3 trillion between the amount of equity capital global firms will need to fund their operations and the amount that global investors will be willing to offer on current terms. To put this figure in perspective, total world financial assets are projected by McKinsey to be $371 trillion.
If this is correct, companies may:
–borrow more, thereby increasing their vulnerability to cyclical economic downturns ( a company always has to service its debt, but can reduce or omit dividends without triggering a default)
–issue equity on less favorable terms to the firms,
–use capital more efficiently, or
–expand more slowly.
I’m going to write about the McKinsey study in two posts. Today’s will outline the McKinsey argument. Tomorrow’s will have my thoughts.
the McKinsey argument
Throughout its analysis, McKinsey divides world financial markets into those in the developed world (the US, Europe and Japan) and in the emerging.
the developed world
A key starting point for McKinsey is the demographic fact that the US and Europe are old–and aging. This list of median ages (from the CIA) illustrates this point. Starting with Monaco, the Florida of Europe, median ages by country range as follows:
Monaco 49 years old
world median 28
Many African and Middle Eastern countries fall in the late teens or early twenties.
Why is this important?
As people become older they gradually shift from wanting to increase their assets to being happy to preserve the wealth they already have. This increasing risk aversion means they are less willing to buy equities.
pension plan shifts intensify this trend
In the US, corporations have pretty much completed the process of transferring the risk of paying for retirement from themselves to their employees. They’ve done this by substituting defined contribution pension plans for defined benefit ones This shift is now under way in Europe. Individuals tend to put a smaller proportion of their retirement assets into equities than the defined benefit mangers would have. In addition, corporations tend to shift the assets in their residual defined benefit plans into bonds to limit their risk exposure.
the emerging world
Although emerging economies will provide most of the growth in the world over the next decade, and have relatively young populations, they are unlikely to generate widespread–and increasing–domestic interest in equities. Two reasons McKinsey thinks so:
–most citizens are too poor to want to take the risk of holding equities, and
–most emerging markets have low standards of financial disclosure, are badly regulated and exclude foreigners. So they’re not places you’d really want to put your money.
In the report, McKinsey attempts to estimate, on a country by country basis:
–how much equity money corporations will need through 2020, and
–the amount that investors are likely to allocate to equities over that period.
McKinsey addresses the first task by trying to project what the total market capitalization would be for each country, based on the assumption that each can obtain all the equity funding it requires to fuel growth.
It assumes that aggregate assets and earnings will grow in line with nominal GDP. It applies a valuation multiple to them that’s derived from a two-stage present value model. McKinsey then adds the results of IPO stock issuance, which it extrapolates from past relationships between IPOs and GDP.
This is a complex process that McKinsey only describes in outline, even it the appendix to the report.
Basically, the consulting firm projects, country by country, future disposable income. It assumes that in the emerging world that individuals continue to put the same fraction of their disposable income into investments and that their allocation between stocks and fixed income remains constant. For the US and Europe, on the other hand, it shrinks the equity portion progressively–citing age as the rationale.
McKinsey estimates that investor demand for equities will grow by $25.1 trillion between now and 2020. However, worldwide corporate demand for equity financing will rise by $37.4 trillion, creating a $12.3 trillion “equity gap.”
According to the analysis, the US will have a slight funding surplus, despite a gradually waning interest in equities by Americans. Europe will face a funding deficit of $3.1 trillion.
The real potential problem is in emerging markets. China is in the worst shape, facing a potential financing deficit of $3.2 trillion. Other emerging markets face a total funding deficit of $7.0 trillion.
That’s it for today. My thoughts tomorrow.